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What Does COP21 Mean for Different Industries?

The Paris Agreement on Climate Change will enter into force on November 4th now that the EU has joined the US, China, India, and others in ratifying the agreement.

Now that the Paris climate agreement is more or less a reality, we turn our attention to how countries across the globe will meet this ambitious commitment. The best indication may come from the so-called Intended Nationally Determined Contributions or “INDCs”. These plans were submitted prior to the Paris COP21 summit, and they outline each country’s domestic plans to achieve the goals of the agreement. Although unfortunately the current plans are not sufficient to keep global temperature increases to less than 2°C, they still probably give us the best indication of how countries plan to curb emissions and ensure physical resiliency.

However, questions remain as to the regulatory and policy mechanisms that countries will use to achieve their commitments—and particularly—which industries will be subject to these regulations, standards, penalties, and incentives. I ultimately want to know how national climate policy will create an environment that affects corporate financial performance, influences capital allocation, and ultimately creates or destroys shareholder value.

I care about these questions because I work at SASB, an organization that develops standardized metrics for companies to use in disclosing material sustainability information to investors. We approach Environmental, Social, and Governance (ESG) topics from the viewpoint of an investor and uncover links between sustainability performance and financial performance.

In order to get a sense of how the Paris Agreement may create material risks and opportunities for companies, we read through countries’ INDCs. We were looking to see which industries were most frequently mentioned as the focus of climate policies and regulation. We wanted to see if there were any trends, surprises, or other insights we could glean from looking at plans across the globe. We accessed the INDCs using the WRI’s amazing CAIT tool (available here).

We classified industries according to SASB’s Sustainable Industries Classification System (SICS) which organizes the economy into 79 industries across 10 sectors, according to shared sustainability factors (available here). And we focused our review on the G20 nations because they account for 74.9% of global greenhouse emissions[1], 82% of global GDP[2], and nearly all of global stock value[3]. These are also the nations of focus for the Taskforce for Climate Related Financial Disclosure being convened by the Financial Stability Board.

What we found

We found that 14 of 79 industries were most frequently singled out. These 14 were mentioned in 9 or more INDCs[4]. Another 15 industries were mentioned in between 4 and 8 INDCs. The remaining 50 industries were mentioned in 3 or fewer INDCs. No a single country mentioned Industries in the Health Care and Technology & Communications sectors, the processed foods industry, or the beverage industries.

Table 1. Most Frequently Mentioned Industries in National Climate Plans

Countries may indeed focus on industries not specifically mentioned, but the INDCs are currently the best indication we have of where regulations and policies are likely to hit the hardest.

What this means

The fact that most climate regulation is likely to focus on 14 industries means that companies in those industries should be paying attention and crafting strategies now. Investors in those companies should view them as having the highest potential impacts (both upside and downside) from climate regulation in the near-, mid-, and long-term. It’s worth noting that SASB’s research does indicate that climate risks are nearly ubiquitous— affecting 72 of 79 industries— but this may be a helpful lens for those looking to identify smaller set of “highest impact” industries. In particular, asset manager and owners with highly diversified portfolios may wish to use these industries as a starting point for prioritizing and assessing climate risk.

Most of the industries in Table 1 shouldn’t come as a surprise. They’re reflective of the major economic sectors that contribute to climate change (see Figure SPM.2 from this IPCC report). But how investors assess the risks and opportunities across these industries may be less obvious.

There has been significant focus recently on so-called “science-based” corporate emissions targets. This approach looks to companies to set greenhouse gas (GHG) emissions reduction goals that mirror the level of decarbonization required globally to keep temperature increases below 2 degrees Celsius compared to pre-industrial levels. This approach makes sense at a global and national level and, indeed, may make sense for certain industries such as electric utilities and other industrial entities that are large emitters of greenhouse gas emissions. However, in industries that are indirect emitters—either through their consumption of energy, their supply chains, and especially from the use-phase of their products—companies should be developing much different targets, using different metrics. For these companies, managing climate risk isn’t as straightforward as saying, “We commit to reduce our GHG emissions by ‘this percentage’ by ‘this date’”.

As the INDCs indicate, many industries may not be directly regulated. Nations will likely not mandate an automotive company reduce its greenhouse gas emissions— they’ll focus instead on vehicle fuel economy standards; nor will they require real estate owners to reduce emissions—they’ll focus on building codes and incentives for certified green buildings.

Therefore, investors should look to public companies to set targets around material climate-related factors using meaningful metrics. And as recent research supports, companies should not allocate capital toward setting targets on factors that may be immaterial.

How SASB can help

Using SASB’s research and standards as a lens, here are a few examples that put this point in focus:

IPCC data shows that buildings are responsible for 6.4% of global direct carbon emissions 12% of indirect emissions from their energy consumption[5]. Further they are at risk for the physical impacts from climate change. Accordingly, many INDCs make mention of the built environment. Specifically, they focus on green building codes, incentivizing green building design and performance standards, sustainable urban planning initiatives, and infrastructure resiliency efforts. Many INDCs mention real estate owners and developers. However, it would actually make more sense to mention the Engineering & Construction industry because it is the industry critical to creating low-carbon, resilient infrastructure in the coming years and decades. The SASB standards contain the following metrics to evaluate Engineering & Construction firms’ climate performance, which notably are not related to direct emissions reductions:

Topic

Metric

Category

Unit

Code

Lifecycle Impacts of

Buildings &

Infrastructure

Number of (1) commissioned projects certified to a multi-attribute sustainability standard and (2) active projects seeking such certification

Quantitative

Number

IF0301-09

Description of process to incorporate operational-phase energy and water efficiency considerations into project planning and design

Achieving the Paris commitment will require net zero emissions before the end of the century. This means a major shift of our energy sources from conventional fossil fuels to renewables such as solar and wind. Accordingly, INDCs mention plans to increase uptake of alternative and low-carbon energy and decrease reliance on fossil fuels. Companies in either sector shouldn’t be communicating to their investors simply their plans to reduce their direct greenhouse gas emissions. They must think in terms of significant market risks and opportunities and set targets accordingly. Renewable energy companies need to communicate how they’re managing growth in an environmentally sustainable and socially equitable manner, and within the constraints of existing energy infrastructure. Fossil fuel companies, in addition to their direct emissions, need to provide data relating to their business model, their capital expenditure plans, the carbon intensity of their reserves, and, perhaps most importantly, their risks of hydrocarbon asset impairment. SASB standards for the Non-Renewable Resources and Renewable Resources & Alternative Energy sectors provide decision-useful metrics on these topics and more.

In the US 26% of greenhouse gas emissions come from the transportation sector[6] (this figure is 14% globally)[7]. In order to reduce these emissions, the United States and other INDCs focus on fuel economy standards and incentives for alternative power train vehicles. The regulatory focus communicated by these plans is not on emissions reductions from drivers but lies upstream on manufacturers. The primary expectation for these companies should not be to reduce direct emissions against a 2-degree pathway—it should be to develop transportation technologies of the future. SASB standards recognize this and recommend metrics for these industries such as:

Conclusions

Although by our analysis climate risks affect 72 of 79 industries across the economy, a smart starting point to assess climate risks in a portfolio may be to look at the risks and opportunities facing the 14 or industries that are likely to be most affected by national climate policy and regulation.

Instead of falling into the trap of thinking that greenhouse gas emissions equate climate risk, look deeper. A focus on reducing emissions for companies in industries with relatively immaterial contributions to direct emissions is at the least a potential distraction to executives and investors, and at most a misallocation of invested capital.

It’s great to see that many companies using science based targets do include commitments to that focus on targets beyond Scope 1 and 2 emissions. The SASB standards can be a way to cut through the noise and identify the portion of the commitment that is likely to be material—financially and environmentally.

Investors need to understand an issuer’s management of those climate risks and opportunities that are linked to financial position and operating performance AND do so in terms that each party understands. The terms Scope 1, 2, and 3 are well worn in the sustainability and ESG communities, but not beyond. However, sales of alternative vehicles and number of commissioned projects are metrics that everyone understands, clearly link to financial value, and can demonstrate sustainability performance relative to policies and regulations.

Science based targets should be left to policy makers and regulations and to those companies that are significant direct emitters of greenhouse gases.